To Buy or to Build

Growth-oriented advisory firms face challenges in today’s environment of rapid consolidation. Those who seek to purchase another practice are encountering high prices and terms geared to the sellers. What is the best growth strategy for your firm? Should you try to buy another practice in a hot market, or should you focus on recruiting and developing organically? Either way, the goal is to build your brand, create capacity, achieve critical mass and construct an enduring business.

A recent conversation with a $2-billion wealth management firm brought this challenge into sharper focus. They have multiple office locations, but only one has reached critical mass. Most are staffed by a single advisor and an assistant. These satellite office practitioners function as rainmakers, lead advisors and quality control officers for their own location.

Advisory firm leaders recognized their high dependency on practitioners who lack deep ties to the organization. These advisors acquire clients through individual relationships, not because of firm brand. They think and act locally, which means that clients are not benefitting from the depth of talent the larger firm has to offer. It would be difficult to argue that clients belong to the firm rather than the practitioner should they part ways.

Value Misperception

Leaders of the firm responded to this challenge with a plan to buy practices in their existing markets and contiguous locations, in an attempt to get to critical mass more quickly. As a result, they made several runs at large advisory businesses, but were priced out of every bid.

Every target acquisition had multiple offers, which made each deal more of an auction than a negotiated purchase. They decided to go down market to smaller practices with the hope of making more affordable purchases. Even when bottom fishing, however, they encountered owners with inflated perceptions of value.

At what point do these prices make sense? Solo practitioners seeking purchase offers typically have just a few years left in their careers. They are looking for meaningful sums to help fund their own retirements — yet their client bases are the same age or older and are already deep into the de-accumulation phase. Within these aging solo practices, client and asset attrition usually outpaces new business development, which occurs accidentally rather than systematically. Not much exists to justify a high price.

Compounding price inflation is an expectation of a larger down payment. In the past, buyers commonly paid 20-30% of the agreed-upon valuation up front, with the balance paid over three-to-five years. Often the remaining payment was tied to performance and client retention, which shifted more of the risk to the seller.

The partners in this specific wealth management firm have become frustrated because seller expectations for price and terms have pushed many deals out of their own risk tolerance. The partners have been reluctant to take on debt to fund transactions, and they have an aversion to private equity because they do not want a passive shareholder in their company.

As they reviewed their strategy, they developed several key threshold questions for evaluating an acquisition target:

• What is the average age of the advisory firm’s clients? • What is the firm’s rate of de-accumulation? • Which staff (including the firm leaders) are likely to remain once the deal is done? • Which clients are at risk in the transition? • What has been the rate of organic growth over the past five years and what drives this? • What is our required rate of return for this investment?

This firm’s diligent analysis spawned an awakening. They decided that building rather than buying would make more sense.

They discovered that solo practitioners tend to use a multiple of revenue as their valuation metric, primarily because they cannot demonstrate free cash flow or EBITA after paying fair compensation to the lead advisor. Being savvy investors, the partners in this wealth management firm recognized that when nothing is left over after covering all expenses including compensation, it is impossible to amortize the purchase price out of current earnings.